Bond

Quick definition

A bond is an acknowledgement of a debt and a promise to repay it.

Key details

• Bonds are typically issued by governments or local authorities as a means of borrowing money
• Bonds are issued for a certain length of time and pay a fixed interest rate
• There is a publicly-tradable market for bonds, with prices based on the risk of default and investor demand

What is a bond?

A term widely used in the to describe fixed-interest securities issued by the State or by local authorities. Bonds may fall into various categories named for convenience ‘long’, ‘medium’ or ‘short’, reflecting the date at which they are redeemable. Irredeemable bonds such as consols are also issued, but these are normally the prerogative of the central government and are incorporated into the national debt.

In the United States – and occasionally in the UK – the term is sometimes applied to company loans, though in such an event the bonds would tend to be secured by fixed or floating charge.

How is a bond different from a share?

The purchase of a listed company’s shares gives the purchaser an ownership interest in the company and a say in key decision-making. Bonds are not ownership interests and bondholders have no say in the company’s affairs. But crucially, bonds take priority over shares in a company’s liquidation.

Where there are some similarities between bonds and shares is that a bond also functions as a tradable investment product. There are active markets, worth many trillions of dollars, in bonds, with the major players being the bonds of sovereign states, which fund government shortfalls between expenditures and tax revenues.

How do you make money from bonds?

There are two key numbers that go into valuing a bond. One is the principle amount borrowed, and the second is the interest rate on that loan. Generally, you make money from bonds from the interest rate, but it is sometimes possible to buy bonds on a secondary market at below their face value.

Bonds are issued for a nominal or face value, which is the amount being borrowed. Most bond issues are for a set term, with a specified maturity date which may be three to five years (a short-term bond), 10-12 years (a medium-term bond) or for a much longer period, such as 30+ years (a long-term bond).

Most bond issues carry a fixed-rate coupon – a specific rate of interest payable at set intervals over the life of the bond, typically bi-annually with government-issued bonds, or annually with bonds issued by companies (corporate bonds). In some cases, the interest rate fixed at the bond’s issue, then adjusted according to an inflation-tracking index, such as the CPI (Consumer Price Index).

How are bonds priced?

A new bond issue typically sells into the market at par, meaning its face value, but if there is sufficient demand, a secondary market will quickly form which will start to price the newly-issued bond. The price of a bond is invariably quoted clean – meaning without regard for the interest accrued to date of quotation – though is bought and sold dirty, as explained in the previous paragraph.

Regardless of their face value, bond prices are generally quoted per 100 nominal, and out to two decimal places. So if bond X is in sterling and is being quoted at, say, 104.56, the price being asked is £104.56 for every £100 of the bond’s nominal value.

Once in the secondary market, bonds rarely remain at par – rather they are bought and sold at either a premium or at a discount, meaning either for more or less than their face value. In the example just given, the bond is being offered at a premium to face value of £4.56, so it is a premium bond. But many bonds also sell below their face value, ie they are discount bonds. Whether it’s one or the other is determined by a range of factors but the most influential is the coupon – the interest rate.

It is this which determines the accrued value of the bond over its life-time. If the interest rate is fixed, or is in anyway assumed to stay the same, a given purchase price will determine that bond’s yield – the rate of return generated by the investment at that price and calculated at that time. It’s yield that determines a given bond’s value, and thus price, versus similar bond issues in the market.

What determines a bond’s yield?

Yield is calculated in different ways, depending on the investor’s needs. First, there is the flat yield, which takes into account only the return generated by the coupon and disregards capital gain or loss on the bond throughout its lifetime.

For example, the flat yield on a 4% gilt currently priced at 102.50 would be 3.9%. If the bond’s price rises to 105.75, the flat yield on that bond falls to 3.78%, so demonstrating the inverse relationship between bond yield and price. As a bond’s price increases, its yield falls. As a bond’s price falls, its yield increases.

A more useful, but also more complex, way of calculating yield is to produce for a given bond at the price paid its redemption yield, which can be either gross or net. The gross redemption yield measures the total return that the bond will generate in the period till its maturity and expresses this as a percentage of the bond’s price on an annualised basis.

The particular utility of gross redemption yield is that it allows investors to make comparisons in the pricing of bonds with different maturities and coupons. Net redemption yield is a variation which factors in the impact of taxation on the bond’s cash-flows until its maturity.

Are bonds risky?

It depends on who is issuing the bond, the current economic situation, and whether the market has confidence that the government or company who is borrowing the money is able to repay it.

The price of a bond, and therefore its yield, is not determined by a few different factors. The most influential, after the interest rate, is the market’s perception of default risk in respect of either interest instalments or capital repayment, or both, for which the credit rating given to that bond by a rating agency is critical.

The lowest-risk bonds – those with the highest credit ratings – are issued by central government and are known in the UK as gilts and in the United States as treasury bonds (or T-bills).

Bonds issued by municipal authorities and supranational agencies are also likely to be accorded low-risk status, though not as low as central government issues. Corporate bonds – typically though not exclusively issued by listed public companies – are either investment-grade or else they’ve been rated below investment grade, in which case they typically carry a higher interest rate – and are known as high yield or, pejoratively, as junk bonds.

There are other risk factors also priced into bonds on the secondary market, which include market risk – the prospects of the particular bond failing to attract or maintain sufficient, or indeed any, demand – and of course inflation risk – the prospect that the value of the bond’s principal will be eaten away by inflationary forces in the period to maturity.